Johnson & Johnson's Synthes Deal Revives Foreign Tax Debate

NEW YORK ( TheStreet) -- To make the largest deal in its 126-year history an earnings boost, Johnson & Johnson ( JNJ) is keeping its acquisition of Synthes as far as from the U.S. taxman as possible.

After receiving regulatory clearance for its $19.7 billion acquisition of Swiss medical device maker Synthes, Johnson & Johnson says the mega-deal will add to earnings per share after previously forecasting dilution: All with the help of bankers JPMorgan Chase ( JPM) and Goldman Sachs ( GS).

Johnson & Johnson, the world's largest health care products company, is using a "brilliant" $12.9 billion stock swap between its Irish subsidiary, Janssen Pharmaceuticals, and its bankers JPMorgan and Goldman Sachs to minimize its U.S. tax bill.

The move is sparking a change of opinion from analysts about the benefits of the acquisition and Johnson & Johnson's shares, which have underperformed the Dow Jones Industrial Average in the past year. It also reignites a heated debate about taxation on hundreds of billions in foreign earnings at many of the largest companies in the U.S.

According to an 8-K filing with the Securities and Exchange Commission, Johnson & Johnson said that it will use foreign earnings held at its Irish subsidiary to buy $12.9 billion in its own shares from Goldman and JPMorgan. Those shares, along with some cash, will then be handed over to Synthes to fund the buyout.

To make the deal work, JPMorgan and Goldman will borrow and buy 203.7 million Johnson & Johnson shares in the open market over the next year. J&J will then use cash held at its Irish subsidiary to repay the bankers' J&J stock, the company said in a June 12 filing.

The whole point of the financial acrobatics is to make the company's Irish subsidiary purchase J&J shares and Synthes, thus avoiding a U.S. tax hit.

The share swap with two of Wall Street's biggest banks will replace any stock issuance to fund the cash and stock deal for Synthes, which could have diluted shareholders and led to a hefty tax bill.

That move is expected to "finance the transaction in an efficient manner to enhance shareholder value," said J&J in a Tuesday press release that announced the Federal Trade Commission's approval of its Synthes acquisition. As a result, the company said that merger dance will add up to five cents to its 2012 earnings per share and 15 cents in 2013, after previously forecasting EPS dilution of up to 22 cents.

"Instead of a dilutive stock issuance followed by a share buyback program, the company has borrowed stock through an accelerated share repurchase agreement, which transforms the transaction into an accretive deal," wrote Jefferies analyst Jeffrey Holford, who upgraded J&J's shares to buy from hold, boosting his price target for the company by nearly 6% to $72.

Holford calculates that the move increases J&J's earnings per share by roughly 3% in 2012 and up to 5% a year between 2013 and 2017.

Although regulatory approvals and a string of analyst upgrades on Wednesday are key developments for J&J, which has underperformed the Dow in the last 12 months, the real story may center on the financial engineering of the stock repurchase arrangement.

"It looks like they found a way to avoid the tax on repatriation of foreign earnings," says Robert Willens, a tax expert who describes the stock swap arranged between J&J's Irish subsidiary and its bankers as "kind of brilliant."

Instead of repatriating its foreign earnings held in Ireland through a taxable dividend, as the Internal Revenue Service established in 2011, Willens notes that J&J is using the acquisition and stock swap to utilize its non-U.S. earnings without incurring the tax charges of a repatriation. The move, he says, is not likely to be seen as a dividend paid from J&J's foreign operations to its core U.S. business, headquartered in New Brunswick, N.J.

"The innovation seems to be structuring the transaction outside of the IRS guidelines," adds Willens, who credit's J&J for finding an innovative, tax efficient and money saving way to organize the deal.

Willens notes that were there a corporate tax holiday on foreign earnings, J&J wouldn't have to structure such a share swap. "The deal is right in the midst of that whole debate and discussion," he says.

In a sense, J&J's move is front and center on a larger debate on whether the U.S. government should tax or offer a "holiday" to large corporations, who are sitting on over a trillion dollars in corporate cash, which is mostly held abroad, according to a March 13 analysis by Moody's.

A return of foreign earnings from cash rich international giants like J&J, Apple ( AAPL), Microsoft ( MSFT), Cisco ( CSCO) and Google ( GOOG) could be invested to good use at home where economic growth and unemployment hover at just above a mediocre 2% and 8%, respectively. Currently, billions sit overseas as corporations try to keep their tax bill below U.S. rates.

In 2010, Bloomberg reported that as a result of holding significant earnings in foreign subsidiaries and moving money around the world through a "Double Irish" tax strategy, Google minimized its tax bill by $3.1 billion from 2007 to 2009. Earlier this year, The New York Times reported that Apple uses similar moves to sidestep billions in taxes.

J&J's use of its Irish subsidiary to fund an acquisition on a repatriation tax free basis may raise new questions on how U.S. corporations are taxed, notes David Miller, a partner at Cadwalader, Wickersham & Taft who specializes in cross-border M&A and corporate taxation. "I think the overall policy issue is should this be an appropriate time to tax J&J on its foreign cash?" says Miller, who isn't aware of other transactions that used a similar structure.

"What they are doing is entering a forward contract," adds Miller. Through JPMorgan and Goldman Sachs, Janssen Pharmaceuticals based in County Cork, Ireland is using its cash to purchase J&J stock and transfer it to Synthes shareholders, who will get CHF 55.65 a share in cash and 1.7170 shares of J&J common stock in the $19.7 billion deal. Since the swaps are expected to occur in under a quarters' time, the use of J&J stock to fund roughly two-thirds of the deal may not constitute taxable U.S. property, notes Miller.

But it's still unclear why the company now expects the acquisition to be accretive instead of dilutive to earnings, unless the share repurchase structure was decided on after J&J first announced the deal last April. "It appears J&J came up with a clever mechanism to avoid dilution," says Miller.

Previously, J&J had expected some dilution, over a fully tax efficient use of its cash stockpile. " We'd love to use all our cash, but we want to do it in a tax-efficient manner," said J&J chief financial officer Dominic Caruso on an April 2011 investor call.

Other questions remain about how aggressive J&J is being in attempting to put its foreign cash to work.

By way of its Irish subsidiary, J&J is merging Synthes with its Britain-based DePuy operations. But according to Synthes' investor relations page, the company appears to be headquartered in West Chester, Pennsylvania, potentially making the deal taxable regardless of whether the Irish subsidiary is involved.

J&J spokesperson Al Wasilewski declined to comment on the share repurchase transaction beyond the company's SEC filings and press release. Nevertheless, in its Tuesday 8-K filing, J&J states that foreign tax avoidance is a key benefit of the swap, but cautions investors that the structure of the deal could be challenged.

"While Johnson & Johnson believes that these transactions will allow it to effectuate the acquisition in a tax efficient manner in accordance with applicable law, it is possible that the Internal Revenue Service could assert one or more contrary positions to challenge the transactions from a tax perspective," J&J said in its SEC filing.

"If challenged, an amount up to the total purchase price for the Synthes shares could be treated as subject to applicable U.S. tax at approximately the statutory rate to Johnson & Johnson, plus interest."

Willens says that the IRS is unlikely to block the swap, but it may try to "clamp down" on the tax loophole that J&J and its financiers have uncovered before other large corporations follow suit. That may have a big impact on J&J and its cash-rich peers, as legislative efforts on "tax holidays" and corporate tax rates stall.

Dianne Besunder, an IRS spokesperson, declined to comment for this article, citing a prohibition to comment on an individual taxpayer's matters.

According to Moody's calculations, roughly $700 billion of the $1.24 trillion in corporate cash held by U.S. companies is sitting abroad, with overseas funds representing roughly 70% of the money in cash rich sectors like technology.

Apple holds 66% of its $100 billion cash stockpile abroad, according to Moodys, while tech giants Microsoft and Cisco hold nearly 90% of cash overseas. With over $35 billion in cash, J&J held the sixth most cash of any U.S. company.

To be seen is whether J&J's stock swap in its acquisition of Synthes will spur similar moves by other corporations or a backlash by the IRS or federal government. What is clear is that the deal and its structuring is providing a lift to the shares of J&J.

In Wednesday trading, J&J shares rose over 2% to $64.45 on an improving earnings outlook and analyst upgrades.

Notably, JPMorgan analysts led by Michael Weinstein, raised their rating of J&J's stock to overweight for the first time since the financial crisis hit a boiling point nearly four years ago.

Weinstein highlighted J&J's newly hired chief executive Alex Gorsky and its pharmaceutical growth on the launch of products like Zytiga, Incivo, and Edurant as keys to the company's improving outlook and an expected turn from a share underperformance in recent years. The analyst raised his price target on shares to $74 from $69, in the upgrade.

For more on Johnson & Johnson, see TheStreet's portfolio of the highest yielding drug stocks.

-- Written by Antoine Gara in New York

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